Europe Eyes Chinese Yuan as Future Reserve Currency

In a surprising move, the European Central Bank is considering buying Chinese yuan as a reserve currency.

According to a report by Bloomberg, anonymous sources in the ECB have said that the Governing Council of the bank will discuss the possibility during its meeting on October 15th. The decision will come amidst decelerating inflation in both Europe and Asia that has increased the risk of deflation in developed nations. A stronger dollar and falling commodity prices have placed the eurozone in a tricky situation in which their options for reserves are shrinking.

Dollar Strength, Yuan Liquidity

The euro has shown accelerating weakness in recent months, as its value against the dollar slides far beyond resistance at 1.325 and below 1.300 in September. The euro was down over 7% year-to-date against the U.S. dollar by the end of Friday trading.

The dollar has strengthened against most world currencies in recent weeks, as a flight to quality trend has picked momentum, driving investment away from equities and toward cash reserves in stable currencies. The Swiss franc has gained over 2.4% against the euro so far in 2014, and 5.6% against the Japanese yen.

At the same time, the yuan has gained 6% against the euro in 2014 as growth concerns in the eurozone exacerbate losses in currency markets. At the same time, more confidence in the reliability of Chinese economic controls, combined with less growth options in foreign markets, have caused a continual rush of investment in Asia’s largest economy, bolstering the yuan while also providing more exchange-rate stability.

Despite its declining volatility, the yuan has failed to take off as a reserve currency, according to the International Monetary Fund. Meanwhile, the IMF sees the U.S. dollar ranked as the top reserve asset, at 61% of holdings.

Analysts believe the move will help offer greater liquidity between China and the ECB, while also bolstering trade partnerships between the two regions. The eurozone is currently the largest importer of Chinese goods. “Due to the size of China’s economy and its importance in global trade and, potentially, finance, the renminbi might ultimately come to challenge the U.S. dollar,” said Yves Mersch, ECB Executive Board member and Central Bank of Luxembourg Governor, at a meeting in February.

Gold, Oil Falls

Gold continued its slide on the news, as the metal showed weakening demand on improved capital reserves offset prior demand acceleration after Basel III reclassified gold as a lower-risk asset that banks could use to shore up balance sheets. Gold remains roughly flat for 2014, after erasing most of its gains in August and September amidst fears that disinflation was worsening in Europe and America.

Similarly, oil has slid over 16% from its peak earlier in 2014 as a perceived glut and decline in commodity demand indicate less room for price growth in raw materials and energy. Analysts believe that oil, which fell below $90 a barrel for the first time in two years last week, could fall even further amidst accelerating production in the U.S.

With the declining value of gold and oil, central banks are looking to store wealth in a more liquid and less volatile asset. While the U.S. dollar has been the primary target for central banks, its recent strength may be inspiring the ECB to consider the yuan as an alternative.

Professor at Columbia University. Recipient of the Nobel Memorial Prize in Economic Sciences in 2001 & the John Bates Clark Medal in 1979. Author of "Freefall: America, Free Markets", "The Sinking of the World Economy", "Globalisation and its Discontents" & "Making Globalisation Work".

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